Last week we looked at Alexander Forbes, a company whose management felt the need to increase its shares in issue in exchange for cash, in order to strengthen its financial position. Hot on the heels of the Forbes results followed the Telkom announcement. Earnings exceeded market expectations with earnings per share up nearly 50 percent and a 22 percent increase in the dividend.
Like Forbes, Telkom used cash to reduce debt. However, unlike Forbes, Telkom did not issue any shares to achieve this; in fact the company bought back shares in addition to reducing some debt.
The circumstances and the impact of changes in the shares in issue are of great interest to the investor. Each shareholder wants to get something back from the company. The more shares there are, the more mouths to feed, so to speak.
The concept of share buybacks, which is when a company buys back its own shares and effectively reduces the number of shares that are in issue and available to trade on the market, has gained some momentum in the past few years in South Africa (Woolworths, Venfin and Tigerbrands are examples where buybacks have taken place).
Internationally, it has a strong following and there are even funds that concentrate on investing in companies that have the potential to do buybacks. Globally, there is evidence that the share price of a company that has bought back shares has a good chance of showing strong returns thereafter.
The reasons for buybacks can be summarised as follows:
Firstly, if a company uses debt to buy back shares, it can save tax as it is not earning taxable interest on the excess cash that was idle. Secondly, it is usually a signal of a strong commitment by the company to creating shareholder value. Rather than wasting excess cash getting bigger but not necessarily better, it spreads its efforts over fewer shares, giving each shareholder more return.
However, the heart of the buyback issue is that a company is unlikely to buy back its shares if it thinks they are expensive! So it is often a good sign that the shares are undervalued.
The appeal of the buyback is that it reduces the capital base and "sweats" the assets harder for each share in issue.
Consider the human body as an analogy. The right mix of fat and muscle is needed to function optimally. Too little fat, and you have no reserves to draw on during times of stress or poor health. Too much fat, and you lose agility and become sluggish, until you work off the excess fat. A company needs to have the right level of capital in order to work hard enough to turn out good profits and not be sluggish, but not so little that it cannot weather bad times.
Alexander Forbes needed to issue shares because some of its operations needed more resources than the company had initially anticipated. This is like refueling after a gruelling race and building up some fat in order to recover. On the other hand, Telkom experienced much better times, and found that it never needed all of its cash, and had a little excess, which it reduced by buying back shares.
Conversely, the most basic reason for issuing shares is because you need more capital, either to fund your current business or for an acquisition. In the first case, management may do so reluctantly, as they may feel the shares are undervalued but are unwilling or unable to take on more debt. It was a strong trend in the 1990s for companies to issue shares for acquisitions. Very often, these acquisitions and share issues took place when the company's shares were trading at a very high price-to-earnings ratio (p:e). So at the time of the deal, the company exchanged a high-priced asset (its shares) for an asset it believed to be cheap (the company they bought). This strategy worked as long as the acquisitions lived up to expectations. Many high p:es came tumbling down eventually as the extra shares dragged returns down.
The key is to understand the reasons and circumstances behind the company's actions when it comes to issuing and buying back shares.
Telkom and Forbes are great examples where a good investment case can be made for both shares - Forbes has taken steps to strengthen its profit potential, and Telkom is using the cash from an excellent run, wisely to buy back shares. Both are at p:es well below that of the market.